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Derivatives and regulation

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Derivatives and regulation

A committee of the U.S. House of Representatives voted yesterday to regulate trading in derivatives. Congratulations on the first step! Unfortunately, this measure is part of a much larger bill to overhaul the regulation of the financial system, which will be debated by the full House and Senate. This measure could easily be sacrificed as lobbyists for the financial industry pressure the members of the House and Senate to water down the entire bill.

As reported in yesterday’s New York Times: “The financial services industry alone has poured more than $220 million into lobbying in 2009, much of it in anticipation of this Congressional effort now beginning.” (We would be better off if this money went for bonuses instead of lobbying.)

The U.S. system of government has become dysfunctional because legislators attempt to craft multi-faceted and complex bills. This opens the door for extensive criticism and horse trading. Simplicity and focus should be the order of the day.

The measure approved by the committee should be a stand alone bill, and should be debated on its own merits, of which there are several. Breaking down a complex, and largely incomprehensible piece of legislation into a number of separate, smaller and focused bills would make it easier for the public to follow debates, and while this would not prevent deal making, it might make deal making more difficult.

It is important for lawmakers to understand that derivatives serve two purposes. They provide a means for gambling. I often have told my students that if they truly want the adrenalin rush from gambling and also want to blow their brains out quickly, trading derivatives such as options, futures and credit default swaps is the way to go.

Derivatives also provide a very efficient means, and in some cases the only means, for individuals and companies to hedge against specific risks. In other words, they provide a form of insurance.

Governments already are involved in regulating and benefiting from gambling. So it’s a simple step to make trading in all types of derivatives transparent and require that trading takes place on an exchange (why not let casinos create some of the exchanges). Throw in a little Tobin tax and governments can benefit as they do from lotteries and other forms of gambling.

As an insurance product, derivatives should be subject to rules similar to those in place for more traditional forms of insurance. If credit default swaps had been regulated as an insurance product, we might have been able to avoid the worst ravages of the financial crisis.

Even complex, negotiated derivatives which act as insurance should not escape regulation, particularly if one of the parties is a bank, insurance company or other regulated financial institution. Transparency is critical, and all stakeholders should know the risks such companies are bearing as they sell insurance to their clients.

The black boxes behind most derivatives cannot hide the roles for derivatives, and their complexity should not be accepted as an excuse for exemption from regulation.


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